1 Strategic Investment and Non-Price Competition

2 Research and Development

3 Introduction Technical progress is the source of rising living standards over time Introduces new concept of efficiency –Static efficiency—traditional allocation of resources to produce existing goods and services so as to maximize surplus and minimize deadweight loss –Dynamic efficiency—creation of new goods and services to raise potential surplus over time

4 Introduction 2 Schumpeterian hypotheses (conflict between static and dynamic efficiency) –Concentrated industries do more research and development of new goods and services, i.e., are more dynamically efficient, than competitively structured industries –Large firms do more research & development than small firms

5 A Taxonomy of Innovations Product versus Process Innovations Product Innovations refer to the creation of new goods and new services, e.g., DVD’s, PDA’s, and cell phones Process Innovations refer to the development of new technologies for producing goods or new ways of delivering services, e.g., robotics and CAD/CAM technology We mainly focus on process or cost-savings innovations but the lines of distinction are blurred—a new product can be the means of implementing a new process

6 A Taxonomy of Innovations 2 Drastic versus Non-Drastic Innovations Process innovations have two further categories Drastic innovations have such great cost savings that they permit the innovator to price as an unconstrained monopolist Non-drastic innovations give the innovator a cost adavantage but not unconstrained monopoly power

7 Drastic versus Non-Drastic Innovations Suppose that demand is given by: P = 120 – Q and all firms have constant marginal cost of c = $80 Let one firm have innovation that lowers cost to c M = $20 This is a Drastic innovation. Why? –Marginal Revenue curve for monopolist is: MR = 120 – 2Q –If c M = $20, optimal monopoly output is: Q M = 70 and P M = $70 –Innovator can charge optimal monopoly price ($70) and still undercut rivals whose unit cost is $80

8 Drastic versus Non-Drastic Innovations 2 Now consider the case if cost fell only to $60, innovation is Non-drastic –Marginal Revenue curve again is: MR = 120 = 2Q –Optimal Monopoly output and price: Q M = 30; P M = $90 –However, innovator cannot charge $90 because rivals have unit cost of $80 and could under price it –Innovator cannot act as an unconstrained monopolist –Best innovator can do is to set price of $80 (or just under) and supply all 40 units demanded.

9 Drastic vs. Non-Drastic Innovations 3 Innovation is drastic if monopoly output Q M at MR = new marginal c’ exceeds the competitive output Q C at old marginal cost c $/unit = p Quantity c QCQC c’ QMQM Demand $/unit = p c PMPM QCQC QM QM Demand c’ P M Drastic Innovation: Q M > Q C so innovator can charge monopoly price P M without constraint NonDrastic Innovation: Q M < Q C so innovator cannot charge monopoly price P M because rivals can undercut that price MR Quantity MR

10 Innovation and Market Structure Arrow’s (1962) analysis— –Innovative activity likely to be too little because innovators consider only monopoly profit that the innovation brings and not the additional consumer surplus –Monopoly provides less incentive to innovate that competitive industry because of the Replacement Effect Assume demand is: P = 120 – Q; MC= $80. Q is initially 40. Innovator lowers cost to $60 and can sell all 40 units at P = $80. Profit Gain is $800–Less than Social Gain $/unit Quantity B A 4060 Initial Surplus is Yellow Triangle--Social Gains from Innovation are Areas A ($800) and B ($200) But Innovator Only Considers Profit Area A ($800) 120

11 Innovation and Market Structure 2 Now consider innovation when market structure is monopoly –Initially, the monopolist produces where MC = MR = $80 at Q = 20 and P = $100, and earns profit (Area C) of $400 –Innovation allows monopolist to produce where MC = MR = $60 at Q = 30 and P = $90 and earn profit of $900 –But this is a gain of only $500 over initial profit due to Replacement Effect—new profits destroy old profits $/unit Quantity C A MR Demand Monopolist Initially Earns Profit C—With Innovation it Earns Profit A—Net Profit Gain is Area A – Area C Which is Less than the Gain to a Competitive Firm

12 Innovation and Market Structure 3 Preserving Monopoly Profit--the Efficiency Effect Previous Result would be different if monopolist had to worry about entrant using innovation –Assume Cournot competition and that entrant can only enter if it has lower cost, i.e., if it uses the innovation –If Monopolist uses innovation, entrant cannot enter and monopolist earns $900 in profit –If Monopolist does not use innovation, entrant can enter as low- cost firm in a duopoly Entrant earns profit of $711 Incumbent earns profit of $44 –Gain from innovation now is no longer $900 - $400 = $500 but $900 - $44 = $856 –Monopolist always has more to gain from innovation than does entrant—this is the Efficiency Effect